The Tax Court in Dagres, (2011) 136 TC No. 12, recently ruled that Dagres, a venture capitalist, could claim a $3,635,218 business bad debt deduction on his individual tax return under Section 166(a) of the Internal Revenue Code for the amount he forgave on a loan made to a business acquaintance in order to strengthen their business relationship and ensure that the borrower would first inform him of promising investment opportunities.
Under Section 166, business bad debts are deductible as ordinary deductions when the loan becomes either partially or totally worthless. On the other hand, personal bad debts are deductible as short term capital losses only when the debt becomes totally worthless. So, if you have a bad debt, you want it to be a business bad debt.
In reaching its conclusion that the loan was made in connection with Dagres’ trade or business, the Tax Court determined that:
– Dagres was an employee of a management company and a managing-member of several limited liability companies in the trade or business of managing venture capital funds, not simply investment.
– The venture capital business of the funds was attributable in part to Dagres.
– His dominant motivation for lending the money was to gain preferential access to companies and deals in order to use that information in the venture capital activities.
– The loan was proximately related to those venture capital management activities.
– Dagres’ business promotional activities constituted a trade or business, not merely investment activity.
The Tax Court’s ruling in Dagres serves as a road map to achieving preferential tax treatment for the VC loan-gone-bad. In the current economy, this Section 166 deduction may prove to be a valuable tool for investors suffering losses due to forgiven loans.
If would like more information regarding tax laws and how they impact you or your business when making loans or other investments, please contact Greg Johnson, lawyer and CPA, at (434) 817-3100 or by email at firstname.lastname@example.org.
Gregory M. Johnson, the author of this post, is an attorney and certified public accountant in the Charlottesville, Virginia office of MartinWren, P.C., where he chairs the Business, Corporate, & Tax Law practice area and regularly advises businesses and individuals on tax and other legal issues.